What fading stimulus means for investors?
As the latest wave of the pandemic recedes and the world adapts to living with COVID-19, pent-up demand in areas such as travel and entertainment should help sustain economic growth, paving the way for central banks to rein in pandemic-era stimulus. However, some investors might be concerned that central banks could move too swiftly to tighten monetary policy, causing economic recovery to cool. In our view, the outlook for most of the world’s major economies over the coming months is favorable on balance despite headwinds, and we see attractive opportunities for investors focused on fundamentals.
Central Banks Prepare for Tough Balancing Act
The withdrawal of extraordinary monetary accommodation in the US and other developed markets is likely to be a key headwind to global recovery. The ability of the US to short-circuit a deep recession after the outbreak of the pandemic relied on the Federal Reserve’s ability to monetize the nation’s debt without sparking inflation.
How today’s elevated bond and equity valuations will respond to the normalization of monetary policy remains an open question. Past tapering episodes have often, but not always, sparked market corrections. In this instance, central banks are walking a tightrope. For the bull market to survive, the Fed’s actions will have to be carefully communicated, resulting in a measured rise in interest rates accompanied by continued growth and moderating inflation.
While fading stimulus might pose some challenges for investors, it also presents opportunity by making markets more efficient. Extreme monetary stimulus from the Fed and other central banks has interfered with price discovery by introducing a major buyer that is completely price insensitive. In particular, the Fed’s commitment to buy USD 80 billion in Treasuries and another USD 40 billion in mortgage-backed securities (MBS) every month, no matter what, has made the real “price” of both unknowable. This has been a boon for US homeowners in the case of MBS, perhaps, but a problem for investors, given that Treasuries form the reference price for assets globally.
The Pandemic Response May Reinforce Disinflationary Trends in the Long Run
Inflation is another challenge for investors but likely a transitory one. Higher inflation typically brings higher interest rates, which weigh on bond prices. Significantly higher inflation has also depressed equity valuations in the past.
While this cyclical burst of inflation still looks to have room to run, the first signs that inflation is peaking may have already emerged. Used car prices have stabilized, for example, and lumber prices, if up somewhat in recent weeks, are still at a fraction of their spring peak.
Over time, I expect the powerful disinflationary trends of the past few decades – including aging demographics, globalization and automation – to reassert themselves. The massive shift to online shopping during the pandemic has accelerated the ease in comparing prices across sellers, a major factor in keeping prices down, while “teledoc” medical visits and internet video conferencing are also disinflationary.
Equity Returns Likely to Moderate while Selectivity is Key
The flood of liquidity has clearly led to speculation in some parts of the market, but it is difficult to generalize about where these pockets of excess lie and how to avoid them. In my view, the strong recent performance in some asset classes is another argument for maintaining a highly diversified portfolio.
Indeed, while the withdrawal of stimulus heightens risks, the return of price sensitivity in global markets bodes well for selective investors focused on fundamentals. While I do not expect robust overall equity returns given the market’s elevated valuations, I am also mindful that investors have not yet enjoyed all the potential fruits of the recovery. Identifying the companies that are either regaining their footing or disrupting markets through innovation will be key.
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